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Abstract
This paper explores the effect of internal control weaknesses (hereafter ICW) and their remediation on information precision for firms who filed Section 404 reports with the SEC. First, we find that the presence of ICW is associated with lower precision of both public and private information. Second, we find that the effect of ICW on public information precision is stronger for firms with firm-level ICW than for those with account-specific ICW. However, we find no such a relation for private information precision. Third, we find that the precision of both private and public information are higher for firms remedying previous weaknesses relative to firms who do not remedy their weaknesses. Further analyses indicate that overall information uncertainty is higher for ICW firms than non-ICW firms. However, we find no difference in consensus among investors between ICW and non-ICW firms. The results suggest that lower precision of public information is offset by lower precision of private information such that consensus among investors is not affected. Finally, we find that firms with different internal control opinions in successive years exhibit changes in precision of public and private information, consistent with our prediction.
JEL classification numbers: H32, D8
Keywords: Internal control weaknesses, Information quality, Firm-level/account-specific weaknesses
(ProQuest: ... denotes formulae omitted.)
1 Introduction
Section 404 of the Sarbanes-Oxley (SOX) Act of 2002 requires management to report on the effectiveness of the internal controls over financial reporting and auditors to attest to the validity of these reports. However, in response to SEC registrants' argument that high implementation costs are not commensurate with its perceived benefits (e.g., Ongeva et al. 2007), Congress recently passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (thereafter Dodd-Frank Act), which affords small issuers an exemption from the internal controls auditor attestation requirement of Section 404. Although regulators and auditors argue that Section 404 requirements should lead to a higher quality of financial reporting, and in turn lower cost of capital (Donaldson, 2005b; KPMG, 2005), research results regarding the success in achieving these goals are mixed.4 One effective way to study the economic consequences of this Act is to directly explore the channels by which Section 404 audit reports affect investor (or analyst) behavior and sort out the source...